Research in Accounting Regulation 23 (2011) 177–183

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Research in Accounting Regulation 23 (2011) 177–183

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Research in Accounting Regulation
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Research Report

Changing audit risk characteristics in the public client market Gary Giroux a,⇑, Cory Cassell b
a b

Texas A&M University, United States University of Arkansas, United States

a r t i c l e

i n f o

a b s t r a c t
Financial audit services have changed in the US over the last half century, resulting in distinct cyclical patterns of relative audit risk. The purpose of this project is to describe changing patterns in the economic and institutional risk environment over time and investigate differences using empirical surrogates as measures of relative audit risk. Economic, competitive, and regulatory differences are analyzed over the period of study. Particularly important events included the Foreign Corrupt Practices Act of 1977 (likely reducing audit risk), the elimination of rules against advertising and direct solicitation in 1979 (increasing audit risk), the Private Securities Litigation Reform Act of 1995 (increasing risk), and the collapse of Arthur Andersen and Sarbanes–Oxley Act (2001–2002, reducing risk). Empirical models are used to evaluate financial risk (Altman’s Z-score), earnings manipulation risk (Sloan’s measure of accruals), and litigation risk (litigation index). Averages by year suggest cyclical patterns of relative audit risk that parallel regulatory, economic and institutional changes over the period. Ó 2011 Elsevier Ltd. All rights reserved.

Article history: Available online 31 July 2011 Keywords: Audit risk Sarbanes–Oxley Act Altman’s Z-score Litigation risk

Over the last 40 years the market for audit services has changed dramatically. Reasons include the cyclical nature of the economy, technology, changes in audit firm competition, varying litigation rates, and the dynamics of audit regulation and enforcement. Consequently, relative auditor risks have moved in cyclical patterns, resulting in observed shifts from conservative auditing practices to condoning relatively high-risk client behavior. The objectives of this project are to: (1) describe shifting economic and institutional risk environments over time and (2) investigate risk differences using empirical surrogates as measures of relative audit risk. We examine the characteristics of public audit clients (that is, corporations trading on major exchanges with available data from the Compustat database) over time, with a focus on audit risk (also called earnings manipulation risk), financial (client business) risk, and litigation ⇑ Corresponding author. Address: Texas A&M University, Dept. of Accounting, Mays Business School, College Station, TX 77845, United States. E-mail address: (G. Giroux). 1052-0457/$ - see front matter Ó 2011 Elsevier Ltd. All rights reserved. doi:10.1016/j.racreg.2011.06.009

(or auditor) risk. Auditors are expected to retain riskier clients and tolerate more aggressive client financial reporting behavior during periods of low regulatory oversight and booming economic conditions, then reverse positions under periods of economic uncertainty and greater levels of regulatory oversight. Audit–client alignments should be based on these three expected auditor risk factors (audit risk, financial risk, and litigation risk). Audit risk measures the probability a material misstatement will affect the financial statements but not be found by the auditor. Financial risk measures the risk related to the financial health of the client. Litigation risk measures the probability of the auditor being sued because of perceived audit failure. The extant literature does not explore in detail how audit firms adjust their client portfolios to accept risky clients or tolerate relatively risky client financial reporting behavior (e.g., earnings manipulation) over extended periods based on changing economic and...
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